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Specifically, tough negotiations over the implementation of the so-called 鈥渇reebie basket鈥� in new core and upper mid-market private credit deals are rife, say market sources, and a number of lenders have already agreed to the new terms.

鈥淚n some instances, on very good credits with strong sponsors, we are seeing unitranche and private debt deals done with high-yield style covenant packages,鈥� said Megan Lawrence, leveraged finance partner at Proskauer.

In the large-cap private credit space, she says legal document terms, in some instances, are converging with the syndicated loan markets.

Providing headroom for additional debt under a Credit Facilities basket has long been a staple in the high-yield market and has become a cornerstone of additional debt flexibility for borrowers needing an extra turn of leverage. Its prevalence (under the 鈥渇reebie basket鈥� moniker) has also been on the increase in mid-cap leveraged loan documents.

Now, sponsors are pushing for these more flexible terms in private credit deals thanks to the fierce competition for new business between the broadly syndicated loan and direct lending markets.

Alexander Griffith, private credit partner at Proskauer, confirms that there have been an increasing number of deals over the past 18 months that have added freebie flexibility to certain provisions.

鈥淚n most mid-market deals leverage is moderate,鈥� said Henri Lusa, managing director private debt Europe at Partners Group. 鈥淗owever, there are many occasions in which borrowers request the ability to increase leverage post-closing of the deal.鈥�

Ready to roll

The amount of additional leverage requested by sponsors varies from deal to deal, say market sources, though sponsors are typically seeking flexibility through the freebie basket to add 0.5-1x of leverage.

Activating the freebie basket will be dependent on positive EBITDA performance of the company in question.

Having this flexibility in the documents can cut out further rounds of negotiations between parties if new capital is needed for an acquisition, because the documents are already in place, says Partners Group鈥檚 Lusa.

And, assuming an uptick in M&A activity in the coming months, the capacity to add new debt means both lenders and sponsors are ready to move quickly, when the time comes.

Negotiating flexibility

But despite the increasing number of requests, freebie baskets are currently restricted to the strongest, best-known credits in the private credit space, backed by the biggest sponsors, say market sources. And for the most part, the majority of direct lenders are reticent to offer the provision to would-be-borrowers.

Those that are willing to include the provision may suggest a compromise.

鈥淲e are very focused on the ability of borrowers to incur additional debt,”听said Mark Bickerstaffe, co-head of direct lending at Hayfin, adding that “we sometimes see sponsors preferring a lower opening leverage with the ability to increase post-closing, for example to fund an acquisition. Subject to the right controls, we are open to providing that flexibility in the docs.”

The maths must work too. Despite the highly competitive financing environment, neither banks nor debt funds can accept the prospect of higher debt in documents if the opening leverage has already reached a critical level at closing of the deal, say market sources.

For now, activity is restricted to all but the private credit market behemoths, but the door is ajar for smaller borrowers who may want to get in on the freebie action in the months ahead.

Sponsors will remember which private credit fund managers have accepted the freebie basket provisions on larger deals, says Griffith, and they鈥檒l ask that same lender to accept the provisions on a smaller deal, too.

Be careful what you wish for

Lenders must be confident that borrowers can handle the load and trust the sponsor to jump in to help in times of stress. High leverage can quickly turn into curse, even for promising borrowers.

In one recent example, Arcmont is听听German computer gaming equipment provider听Pro Gamers Group听(Caseking), according to public filings, in part because of the high leverage multiples.

There was fierce competition to fund this HAL Investments portfolio company in 2021 when the sponsor acquired it from Rivean, given that it benefited from a strong demand for gaming equipment from consumers during the pandemic.

But despite reporting improved revenues and operating income in 2023, it missed HAL鈥檚 targets, and the sponsor reduced its expectation of the future profitability of the company.

鈥淚n view of the high leverage of the company and the associated interest expense, the book value of the investment in Pro Gamers was fully impaired during 2023 (effect for HAL of 鈧�131mn),鈥� the 2023 financial report for HAL stated.

Kerstin Kubanek

+44 (0)7442 014 521

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With more investors wanting access to the double-digit yields private credit can offer, fundraising in the retail channel has ramped up. While the proliferation of non-traded BDCs has promoted access to retail investors, interval funds are beginning to hold their own as they become an increasingly popular tool for this group to get in on the action.

There have been several such funds launched in recent weeks. Principal Global Investors began offering a private credit interval fund that lends to companies with $5mn to $50mn of EBITDA. StepStone Private Wealth launched similar fund that will target senior secured private credit investments using a 鈥渕ulti-lender approach.鈥�

鈥淭he interval fund structure offers greater liquidity, accessibility to retail investors, daily share prices, and a perpetual life structure, making it a more shareholder-friendly vehicle for most investors,鈥� said Shiloh Bates, CIO at Flat Rock Global.

In 2020, Flat Rock converted its private BDC into an interval fund, noting investors in these funds don鈥檛 need to be an accredited investor or sign onerous subscription paperwork to invest, thus making it easier to access. Lack of volatility in interval funds and a wider investor reach also factored into Flat Rock鈥檚 decision to convert, according to Bates.

The rise of interval funds

Unlike most closed-end funds that sell shares and then trade on an exchange, interval funds enable investors to redeem or add shares at certain times. Also, they are not publicly traded entities; the daily share prices are what investors buy in at and then can cash out during the next redemption period.

These types of funds are particularly attractive to investors because of their return potential and mandatory periodic liquidity offered through quarterly repurchases of between 5% and 25% of shares at net asset value.

In addition to the lack of the subscription document, you may begin investing right away and earning a dividend immediately, unlike a private-equity-style structure in which it may take months for LPs to be fully invested.

鈥淲e made [StepStone Private Credit Income Fund] available to all investors, not just high-net-worth investors, on a 鈥榖uy with a click鈥� basis, eliminating the friction of subscription agreements,鈥� said Bob Long, CEO of StepStone Private Wealth, the private wealth arm of StepStone Group.

The appeal of interval funds is evident in the numbers. Currently there are 93 active interval funds, representing $89bn in assets under management, according to Intervalfunds.org. There are 43 interval funds pending registration with the SEC.

While still a relatively small market compared with other fund types, interval funds have seen rapid growth in the last decade; assets under management in 2014 were only about $6.5bn.

This is particularly true for credit strategies.

Interval Fund Tracker, another interval fund database, shows more than 50 interval funds manage more than $30bn in credit assets. For its part, real estate fund managers oversee 11 funds with more than $10bn, while there are only five private equity interval funds.

鈥淭here鈥檝e been a lot more interval funds raised recently on a relative basis,鈥� according to Jonathan Gaines, a partner at Dechert.

Whether it鈥檚 because we鈥檙e in the 鈥済olden age鈥� of private credit or the 鈥渄emocratization鈥� of the asset class, as many have touted, LPs are showing no signs of reducing allocations to the space and retail investors are increasingly in the mix too.

In fact, LPs polled by Coller Capital in the summer edition of its biannual Global Private Credit Barometer expect to expand their private credit allocation. Some 70% of LPs said direct lending offered the best opportunities among credit strategies in the next two years, beating out all other debt-investing options.

Not the only fund in town

In addition to interval funds, non-traded BDCs have emerged as another popular way to access the retail channel, and both can earn similar returns, but the case for interval funds can be made by looking at the end investor鈥檚 need and appetite for risk.

Structure should flow from investment strategy, says StepStone Private Wealth鈥檚 Long. 鈥淲e believe that a direct-lending focused strategy complemented by a modest allocation to specialty credit provides a distinctive risk/reward profile for individual investors,鈥� Long said.

Non-traded BDCs may offer redemptions once per quarter but are not required. A decision to halt these redemptions cuts off a liquidity path for the fund鈥檚 investors.

鈥淭he 5% per quarter redemptions in an interval fund are mandatory, while BDC boards typically retain discretion, and thus investors can have more confidence in the liquidity offered in an interval fund,鈥� says Long.

Another attraction of investing in these BDCs would be the leverage, sources say. BDCs can also utilize 2:1 leverage on a debt-to-equity basis, while interval funds limited to 0.5:1 without using preferred stock, according to Gaines.

颅鈥淚f you don鈥檛 need the higher leverage limit or flexibility, it may make sense to consider raising an interval fund since it鈥檚 typically quicker to launch than a non-traded BDC and may be more suitable for certain distribution channels [such as RIAs],鈥� Gaines said.

StepStone鈥檚 Long though said they can meet investor expectations without that extra leverage.

鈥淲hile BDCs do have the flexibility to take on twice as much leverage as an interval fund, we don鈥檛 believe that extra leverage is necessary for the [StepStone interval fund] investment strategy to deliver our targeted returns,鈥� he said.

Still, there鈥檚 no denying the attractive yields these funds BDCs offer, and they will remain a steady source of access to private credit investments. But it doesn鈥檛 need to be an either-or calculation.

鈥淭here is absolutely a place for both听BDCs and interval funds as part of a private credit strategy,鈥� said Gaines.

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